Euro’s Rally Likely Built on Sand

By Nicholas Hastings

It has been built largely on the false premise that all is well with the euro zone and that the current debt crisis in the region is over.

Smooth talking by European Central Bank President Mario Draghi and the repayment of emergency funding to troubled European banks have helped to calm financial markets for now.

The borrowing costs of debtor nations have fallen, international investors have returned, and the euro has rallied by nearly 13% against the dollar since its low in the middle of last year.

Carsten Brzeski of ING Financial Markets put it this way: “Thanks to Mario Draghi’s confidence trick, the euro zone has recently gone through a period of calm. Financial markets are cheerful, private capital is returning to euro-zone peripheral countries and structural reforms seem to bear some fruits.”

Optimists, including Draghi himself, are hoping that this will produce “positive contagion” in which the fresh investment inflows and the lower borrowing costs help the euro-zone economies to recover and that the risks of a debt default finally start to fade.

This optimism has been fed in recent weeks by some stronger economic data from Germany, improved consumer confidence across the region, as well as a greater confidence in the global economic recovery.

However, the confidence trick is already starting to fall apart.

Take Germany.

Yes, its economy is stronger than its euro-zone partners, but (a) as a sharp decline in retail sales last month showed, German domestic demand is not nearly as healthy as previously thought, and (b) as demand in other euro-zone countries shrinks, the economic divergence between Germany and its neighbors is getting even worse.

Take consumer confidence.

The improvement shown in recent figures from the European Commission put sentiment back up at levels last seen in June last year. But strip these numbers down and sentiment in most other countries in the euro zone, including France, declined.

And while the recent repayment of emergency funding from the ECB may have lifted hopes for a recovery in the banking system, there isn’t any sign that the private sector is benefiting. New data from the ECB showed bank credit remains flat and that loans to the private sector are still falling fast.

Then, there’s the global recovery.

Most other major economies continue to edge their way out of trouble. China, in particular, appears to have accelerated away from a hard landing. But even there, growth is expected to flat line later this year and fail to provide the momentum that would help weaker economies recover behind it.

The U.S., however, is providing fresh concerns. Not only did the U.S. economy contract unexpectedly in the fourth quarter of last year but there remains little evidence that avoiding the fiscal cliff will bring much of an upturn early this year.

This suggests investor interest in the euro zone and the euro should soon fade, especially if the ECB itself starts to adopt a more accommodative position.

The end result? The confidence trick that has held the euro up so high for long will no longer work and the single currency will come tumbling back down.